You have to watch this video to believe it. The speculation in the commodities market is well out of hand. Cotton futures are at a record high on speculation that demand in China will continue to increase, as China is the world’s largest importer of cotton. Add in the flooding in Australia and you have the makings of a rally driven by fundamentals but bolstered and amplified by speculation.

Bloomberg explains in the video below.

Breath-taking. There is ample evidence that speculation is a big factor driving prices higher – and not just in markets like cotton.

OK, how can speculation affect this picture? The answer is, it has to work through accumulation of inventories — physical inventories. If high futures prices induce increased storage, this reduces the quantity available to consumers, and it can raise the price. And you can, in fact, argue that something like this has been happening for cotton and copper, where there are apparently large and growing inventories.

But for food, it’s just not happening: stocks are low and falling.

Here’s the thing though.

This is simply not knowable, or at least not to the degree of confidence that Krugman has.

One thing I do on a regular basis is analyze information about market size and activity, and over time, it’s taken place in a very wide range of industries (yours truly specializes in oddball deals). Unless you are dealing with markets in which the government demands extensive reporting (like Japan, the data you can get in Japanese is just fantastic) or ones where you have a system of centralized reporting or other tight controls (like pharmaceuticals), it is very difficult even to get decent estimates of market size. So a basic issue is: understand the integrity of data.

Now consider commodities. Inventories can be held LOTS of places: storage facilities by private owners (major refiners such as flour mills), finished product, private speculators (there have been reports for years of base metal stockpiling in China), even the consumer level (during the oil crisis, people kept their auto gas tanks fuller due to the even-odd license plate gas station system). Consider what a monstrous supervisory apparatus around the world would be required to track all or even a substantial portion of where inventories in various commodities could be held.

The logical fallacy for Krugman is the official inventories he is looking at are only a subset of the places where inventory can be accumulated, and in many if not most cases a small enough subset that he cannot reach conclusions of the absence of inventory accumulation.

Let’s put our thinking caps on for a second. Say you are an American investor. Four years ago, you were getting a decent nominal and real return on your government bond portfolio. You were happy with the yield you were getting on your other bond assets as well and equities were doing just fine. Now, the Fed has short-term rates at zero percent and is engaged in quantitative easing to keep long-term rates relatively low. Meanwhile even the trimmed mean Consumer Price Index is at 2.7%, giving you less than a 1% real return in a reflationary environment. That’s not a whole lot of return for the risk that yields will shoot up. And remember, the losses are much larger per basis point when yields are low than when they are higher. You are not happy. Suddenly, your real return on govies is punk. Yields are so low, it’s as if the central bank is robbing you. What do you do?

Here are two bets people seem to like. With U.S. real yields artificially low, a flood of money is going into emerging markets. Bill Gross is running with the Emerging Markets trade. Why shouldn’t you? Then there are commodities. If you don’t get in that trade now, you are going to be missing a monster rally.

That’s how it works, folks. In the real world, people respond to incentives. And Ben Bernanke is telling us he is going to continue to hold rates low. Why wouldn’t you reach for yield or dabble in commodities?

As for the Chinese farmer, the alleged hoarder, if you are that farmer and you saw food prices going through the roof, what would you do? Again, same logic.

The video below is in Tagalog and about 7 months old from the Philippines but it clearly shows hoarding of rice in the Philippines from as far back as 2008. This has been a big scandal in the Philippines as it was a government decision, ostensibly to ensure an adequate supply of rice. Rumours have swirled about government corruption. As food prices are at record highs again, I am sure there is more of this hidden from view in other places. (See Philippines swimming in rice amid high imports from the Boston Globe last July)

It seems to me Paul Krugman’s analysis here is flawed because he admits to hoarding in one case – cotton – yet dismisses it in an equally likely case – wheat. I suspect his allegiance to his friend Ben Bernanke clouds his judgment here.

It is only a matter of time before we start seeing the videos of Chinese farmers hoarding wheat, and then Dr. Krugman will need to develop another case for why speculation is not a factor in the commodities run-up.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

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